ECONOMETER

There was a stark contrast between the outcome of the weekend’s G8 meeting in Lecce, Italy, and April’s G20 summit in London.  For a start, the tone was far more positive than in London, with Finance Minsters attending the meeting indicating that economic forecasts may need to be revised upwards rather than the steady stream of downward revisions seen over recent months.

The overall tone was one of cautious optimism.  The communiqué noted “there are signs of stabilization in our economies, including a recovery of stock markets, a decline in interest rate spreads, improved business and consumer confidence”.  However, at the behest of the UK the comments “but the situation remains uncertain and significant risks remain to economic and financial stability” was inserted into the final communiqué.   Such an inclusion is logical and at least suggests that officials are not getting to carried away with the improvement in recent data. 

Officials also began discussing “exit strategies” in terms of withdrawing massive global monetary and fiscal stimulus and even requested the IMF look at the issue in more detail.  Whilst it is premature to even discuss exit strategies the comments were clearly aimed at easing bond market concerns about widening fiscal deficits and inflation risks.  As Tim Geithner highlighted, recovery would be stronger if “if we make clear today how we get back to fiscal sustainability when the storm has fully passed”.   Nonetheless, a mere discussion about exit strategy is highly unlikely to remove the current angst that has built up in bond markets globally. 

Additionally, the communiqué included a commitment to develop standards governing the conduct of international business and finance, international regulatory reform, exchange of information for tax purposes and a commitment to refrain from protectionism.   None of these points will move markets this week and all were unsurprising discussion points. 

So what was missing?  The issue of stress tests on European banks was left out of the final communiqué even though it was discussed at the meeting. Reported disagreements with Germany and France over transparency over the publication of stress test results meant that an agreement could not be reached.  This is a big disappointment.  I have written about the issue in two previous posts “European economy in a whole lot of trouble” and “Stress testing European and UK banks” on my blog Econometer.   The fact that more wasn’t done will mean that uncertainty about the health of balance sheets in particular of banks in Germany will remain a constraint to European recovery.  At the least it will make it increasingly likely that in addition to a sharp decline in European growth this year GDP could also drop in 2010.

In addition, economic data continues to lag in the Eurozone compared to the improving signs in the US and elsewhere as highlighted by the huge 21% annual drop in April Eurozone industrial production at the end of last week.  This data even led to another omission with reference to “encouraging figures in the manufacturing sector” previously included in the draft dropped in the final communiqué.   It is clearly too early to talk about manufacturing recovery.

Also missing in the final communiqué was any reference to currencies. Although it was always unlikely that FX would be a major topic at the meeting due to the absence of central bankers attending, the drop in the dollar and concerns from foreign official investors (see a recent post on my blog “Are foreign investors really turning away from US debt”) raised the prospect that there would be some international backing of the US “strong dollar” policy led by the US. 

In the event there wasn’t any comment, but dollar positive comments on the sidelines of the meeting will likely limit any pressure on the dollar this week.  The dollar will be helped by comments on the sidelines of the G8 meeting as well as important comments from Russian Finance Minister Kudrin who stated that he has full confidence in the dollar with no immediate plans to move to a new reserve currency. Ahead of the meeting of BRIC countries this week the comments from Russia add further evidence that there will be no plan to move away from the dollar. Moreover, geopolitical tensions including the protests over the results of Iran’s elections as well as more jawboning from North Korea will work in favour of the dollar this week. 

The euro could look especially vulnerable this week. The lack of attention on European banks stress tests will be a disappointment for those hoping for more transparency and will act as a further drag on the euro.  This is likely to see the euro struggle to make much headway this week, with the recent high above 1.43 likely to provide tough resistance to any move higher in EUR/USD, with a bigger risk of a pull back towards the 1.37-1.38 levels.